Newsletter – December 2014

While we would all like to know which investments will perform best next year, it is always extremely difficult to predict the future. It is even harder to predict what will happen in the short term as inevitably things that we can’t anticipate now will influence outcomes in unexpected ways.

Who, for example, predicted the recent oil price crash? However, as we all need to make decisions without the benefit of hindsight, I will give you my best guess as to what I think might happen to the major investment assets in 2015. Please don’t take these predictions as investment advice as any such decisions should take into account many other factors that relate to your personal circumstances.

Cash and short term deposits – I expect the RBA cash rate to be between 2.0% and 2.5% throughout 2015. Term deposit rates are likely to fall slightly from current levels such that it will be difficult to find anything much above 3.0% from early in the New Year.

Australian Government bonds – the Australian ten-year government bond rate is already down to below 3.0% but may fall a little further if the economy remains weak and the RBA cuts the cash rate. These are safe assets but the return is little above inflation.

Corporate bonds – the search for yield over the last few years has seen the spread (the amount above the government bond rate) on corporate and other higher risk bonds contract significantly. I doubt that there will be any further contraction and in fact I would not be surprised if spreads on high yield bonds increased significantly in 2015, particularly if we see credit defaults from weak sovereign borrowers, like Greece & Venezuela, or weak companies, like marginal US & Russian energy companies. I would stay with high quality in this environment as if spreads rise overseas there is also likely to be an impact on lower quality Australian borrowers.

Australian shares – the Australian share-market looks fairly valued after a flat year in 2014 in which gains in healthcare, some industrial and technology stocks and fund managers were offset by significant declines in miners, mining service companies and energy producers. The weak economic environment will make it difficult for most companies to significantly increase earnings per share. I would not expect the market overall to post a significant increase in 2015 so dividends remain an important focus for investors, particularly given my expectation that interest rates are likely to remain low for a protracted period.

International shares – after further strong increases in 2014, the US stock market looks quite expensive but with the momentum of an improving economy it would not surprise if there were further gains in 2015. However, I believe investors need to be very selective focusing on quality companies as a significant correction seems increasingly likely in the next year or two. In Europe, even though valuations look quite attractive, I can’t enthuse about their prospects given the considerable economic challenges many European countries face. I am more positive on a number of the Asian countries, including India and Indonesia. China, which has seen significant gains in 2014 after several poor years, is harder to predict given excessive credit growth which has the potential to cause disruption. Japan may have another good year as a result of further Yen depreciation.

Australian residential property – in my view there is little doubt that Australian residential property is quite expensive with typical yields after expenses being no more than 3 to 4%. Investors have been enthusiastically pushing prices up in the expectation of significant capital gains and given the likelihood that interest rates will remain low, this may continue for some time. My view is that an investor buying in expectation of significant capital gain needs a relatively long time frame as a pause in price growth, if not an outright correction, seems likely.

Commercial property and infrastructure – both in Australia and internationally, low interest rates and the search for yield have seen strong returns for investors in commercial property and infrastructure assets over recent years. As these drivers are likely to continue in 2015, I would expect continued strong demand for these types of assets though price growth is likely to be lower than seen in recent years.

Likely changes to government benefits that will impact baby boomers

It is no secret that the Australian Federal Government, like governments everywhere in the Western world, is having great difficulty in balancing the budget and, without unpopular tax increases, services and benefits will inevitably have to be trimmed. An ageing population is leading to significant increases in expenditure on healthcare and age pensions so it seems very likely that in coming years the baby boomers will find eligibility for some benefits further restricted, particularly for homeowners and those with significant assets. Many retirees say that they have paid their taxes during their working life and they are entitled to receive something back when they stop work. Unfortunately, the taxes paid during our working lives are not put aside to fund our retirement so benefits have to come from current taxes and other forms of government revenue.

Perhaps more significant than the recent debate around a Medicare co-payment, I expect that the asset test applicable to the age pension will be tightened in coming years, in particular for homeowners. I also think it is likely that some tax will be levied on the superannuation benefits received by people aged 60 and above, perhaps through a tax on fund earnings in the pension phase rather than personal income tax on the pension income received from the fund. As we are all living longer, it will be important to allow for the possibility of such changes when determining what level of income to expect through retirement.

Interest rates – more good news for borrowers but bad news for savers and retirees

For some time I have been of the view that Australian interest rates were unlikely to rise before late 2015 and possibly not until 2016. Even then any rise is likely to be modest. The consensus view until recently has been that US interest rates would rise early 2015 and that the Reserve Bank of Australia would lift our cash rate, which influences all other interest rates, soon thereafter. However, Australia’s weak economic growth in the second half of 2014, modest inflation, low wage growth and the sharp fall in commodity prices have led many economists to revise their forecasts. Almost no one expects Australia’s cash rate to rise any earlier than the second half of 2015 and in fact there is a growing expectation of a cut in the cash rate from the current 2.5% to around 2.0% early in the New Year. Low interest rates are here to stay for quite some time.

While this is good news for borrowers, an RBA rate cut would inevitably lead to a further reduction in term deposits and bank deposit rates more generally, thus reducing the income of savers and many retirees. The continued low interest rate environment should provide support to residential property and the share market despite the widespread view that they are already fully priced.

The Financial System (Murray) Inquiry – some key recommendations

Ex- CBA CEO David Murray released his Financial System Inquiry (FSI) report a week ago and the 44 recommendations have some important ramifications if adopted by the Government, though it is highly unlikely that all will be acted upon. Some key recommendations of interest to investors include:

Dividend imputation should be abolished. The FSI views franked dividends as a “subsidy to domestic equity holders”, and states that for many investors the value of imputation credits received may exceed tax payable.

Tax on the interest income received on bank deposits to be reviewed for potentially more favourable tax treatment to fix another “distortion” and direct savings to more productive outcomes.

Another distorting influence in the existing tax system which should be changed is the capital gains tax concession for assets held more than a year.

Negative gearing, the favourable tax treatment for leveraged investments such as investment property, is also strongly recommended for reconsideration.

The Financial System (Murray) Inquiry – what it might mean for bank shareholders

Retail investors who hold direct shares are on average significantly overweight to banks shares because of their perceived safe status and the attractiveness of fully franked dividend yields of around 5.0%. If the Murray report recommendation is adopted requiring the big 4 banks to hold more capital, in order to reduce the risk of the taxpayer having to assist them during a crisis, this could adversely impact their share prices, at least in the short term. Higher capital ratios will reduce the banks’ return-on-equity (ROE). There’s strong correlation between the price investors are willing to pay and a bank’s ROE, so if ROE trends lower, so might bank share prices.

This newsletter contains general advice. It does not take account of your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision.